Qualifying for the Cash Method Under Section 328

An accounting method determines when financial transactions are reported. The two primary methods are the cash basis and accrual basis, with the main difference being the point at which income and expenses are officially recorded. Under the cash method, income is recognized when payment is received, and expenses are recorded when paid, offering a straightforward view of a company’s cash flow.

In contrast, the accrual method requires income to be recorded when it is earned and expenses when they are incurred, regardless of when the actual cash exchange takes place. The cash method is often preferred for its simplicity and the control it offers over taxable income, and recent tax law changes have broadened eligibility for its use.

Eligibility for Using the Cash Method

A business’s ability to use the cash method of accounting is governed by the Internal Revenue Code’s gross receipts test. For 2025, a business meets this test if its average annual gross receipts for the three preceding tax years do not exceed an inflation-adjusted threshold. To calculate this average, a business sums the gross receipts from the three prior tax years and divides by three.

The election is available to C corporations and partnerships that have a C corporation as a partner. Other entities, such as S corporations and partnerships without C corporation partners, are permitted to use the cash method even if their receipts exceed the threshold. However, the rules prohibit certain businesses from using the cash method regardless of their size, with a primary exclusion applying to tax shelters.

Determining eligibility also involves aggregation rules, which require that the gross receipts of all persons treated as a single employer be combined. This includes businesses under common control, such as parent-subsidiary or brother-sister controlled groups. If the combined average annual gross receipts of these related entities exceed the inflation-adjusted threshold, then none of the individual businesses within the group can use the cash method. This provision prevents businesses from splitting into smaller entities to circumvent the gross receipts test.

Information Needed to Change Accounting Methods

To switch from the accrual to the cash method of accounting, a business must file IRS Form 3115, Application for Change in Accounting Method. This form is the central document for the process and requires detailed information about the taxpayer and the nature of the change. Before filing, a business must gather specific data to complete the form accurately.

The form requires basic taxpayer identifying information, such as name, address, and taxpayer identification number. It also requires the Designated Automatic Accounting Method Change Number (DCN), which for this specific change is 233. The taxpayer must also provide a clear description of both the present method of accounting (accrual) and the proposed method (cash).

A component of Form 3115 is the calculation of the Section 481(a) adjustment. This adjustment is necessary to prevent any income or deductions from being duplicated or omitted as a result of the accounting method change. It represents the cumulative difference between the income and expenses that were recognized under the accrual method versus what would have been recognized under the cash method up to the beginning of the year of change. For example, the calculation would include accounts receivable that have been recorded as income under the accrual method but for which cash has not yet been received. It would also account for accrued expenses that have been deducted but not yet paid, and the net result of these adjustments is the final adjustment reported on the form.

Making the Cash Method Election

The process of making the election is procedural. Because this is an automatic consent procedure, a taxpayer does not need to wait for explicit approval from the IRS before implementing the change. The filing process consists of two distinct and mandatory steps.

First, the original, signed Form 3115 must be filed with the IRS. This step must be completed no later than the due date of the federal income tax return for the year the change is to take effect. The form’s instructions provide the correct filing address.

Second, a copy of the same Form 3115 must be attached to the taxpayer’s timely filed federal income tax return for the year of the change. For example, if a calendar-year business is making the change for the 2025 tax year, a copy of the form must be included with its 2025 tax return filed in 2026. After completing both filing actions, the business can begin using the cash method for that tax year.

Reverting from the Cash Method

A business that has changed to the cash method of accounting must continue to meet the eligibility requirements in subsequent years. The primary reason a business would be required to change from the cash method is failing the gross receipts test. If a company’s average annual gross receipts for a three-year period exceed the inflation-adjusted threshold, it will no longer qualify to use the cash method.

When a business fails this test, it is required to change to a permissible method, which is the accrual method. This change is not optional, and the business must cease using the cash method for the tax year following the year it becomes ineligible. To make this required change, the business must again file Form 3115 using the automatic change procedures, which does not require advance approval.